The statement was seen by many as a snub to finance ministry officials who appeared to be on an overdrive to hold on to their rather strict interpretation of the potency and reach of proposed new anti-avoidance provisions in tax laws, despite the change of guard at the ministry. If Thursdays draft guidelines are to be approved and issued under a statutory GAAR, then the attraction of not only Mauritius but also Cyprus as bases for investment in Indian securities will wither away, tax experts said.
In his first meeting with North Block officials after taking over the finance portfolio, Prime Minister Manmohan Singh talked about the need to address the problems on the tax front to revive investor interest and propel growth.
However, finance secretary RS Gujral, who had a meeting with the PM's principal secretary Pulok Chatterjee earlier on Thursday, strongly denied later in the day reports that the introduction of GAAR might be deferred further from April 2013 and issued the draft guidelines apparently hurriedly.
Gujral and other ministry officials under former finance minister Pranab Mukherjee had taken a firm stand that GAAR would prevail over even the India-Mauritius tax treaty meaning that investors based in the island nation wouldn't escape tax on short-term capital gains in India if the relevant arrangement was found to be impermissible.
Gujral, however, sought to play down the PMO move. Don't read too much into the release by the PMO. The PM has not applied his mind (on the draft GAAR guidelines), he said, when asked why the PMO issued a press release on GAAR.
As per the draft rules, an entity, even if based in Mauritius or Cyprus, will have to pay a 15% tax on short-term capital gains arising from their investments in Indian stocks, if the tax authorities reckon that the relevant arrangement is impermissible. The clarification that GAAR provisions won't be invoked against non-resident investors brings little relief as foreign institutional investors (FIIs) through which they invest might come under the tax net under the draft rules. Non-resident investors not allowed to directly trade in Indian stocks use the participatory note (PN) route to invest in the country and take the benefit of the India-Mauritius treaty to avoid paying tax. This route would be virtually closed if the draft GAAR rules were implemented, said Rahul Garg, executive director at PwC.
Investors said they hoped the final rules would limit discretion and scope for interpretation so that chances of litigation come down. The draft GAAR rules are not materially different from the earlier prescription. The basic problem of leaving key definitions open-ended is not being resolved, said Phani Sekhar, fund manager at Angel Broking. Sekhar, however, said that the reconciliatory voices coming from the government after the change of guard in the finance ministry was welcome.
Where an FII chooses to take a treaty benefit, GAAR provisions may be invoked in the case of the FII, but would not in any case be invoked in the case of the non-resident investors of the FII, the draft guidelines said. Of course, if the FII opts not to claim treaty benefits and pays domestic taxes (short-term capital gains tax), then it would be relieved of GAAR scrutiny.
The rules, however, will not be applied retrospectively, as many investors had feared, and would apply only to income accruing from April 1, 2013. Defining an income threshold also has been suggested for invoking the GAAR although the level was not specified. Further, the onus of proving tax liability would lie with the tax authorities. Also, time limits have been proposed for completion of various actions under GAAR.
GAAR, based on the substance-over-form doctrine, is meant to address aggressive tax planning by investors by creating structures/arrangements that lack commercial purpose, with the "main purpose" to evade tax. Sudhir Kapadia, national tax leader at Ernst & Young, pitched for a straightforward carve-out from GAAR for all portfolio investments both FIIs and PN holders. He added that the proposal not to exempt capital market transactions from GAAR's ambit was a let-down for the FII community and would hurt foreign investments in India.
Officials also said the PMO would come up with an "explanatory note" on FII investments in equities and debt. The quest for addressing the issues that dampened investor interest in Asia's third largest economy comes in the wake of reports that Manmohan Singh was unhappy with the way Mukherjee handled the tax proposals in the Union Budget in March. Singh said at a meeting of senior officials on Wednesday that "reviving investor sentiment" was his top priority.
The uncertainty about taxes had led some investors to reduce investments in India, with $926.8 million in outflows from the markets in April, sharply down from a combined $12.3 billion of inflows from January to February.
A finance ministry official said the government recognised that a revival of capital inflows would prop up the equity market and bring retail investors into mutual funds. This in turn would deter investments in gold and other assets, which widen the current account deficit.
India's economy grew at its slowest pace in nine years in the March quarter; the rupee is the worst performing currency in Asia this year; inflation is persistently high; and the country faces the threat of having its credit rating downgraded to junk status.